Bank of Canada hikes key policy rate as expected
Author: Mark Weinberg
July 12, 2017
As widely expected, the Bank of Canada (BoC) raised their target for the overnight rate by 25 basis points to 0.75%, its first increase in almost seven years. The hike was well telegraphed and fully anticipated, with more than 90% of market participants expecting a hike in the three days preceding the decision (figure 1). The market had ratcheted up its expectations of a hike as early as June, following Senior Deputy Governor Wilkins’ comments regarding the strength of the economy. Comments were further echoed by Governor Stephen Poloz in the subsequent days through a series of speeches and interviews, reaffirming the central bank’s stark policy shift.
Figure 1: The market-implied probability of a July rate hike
Source: Bloomberg, as of July 11, 2017
Factors Behind the Central Bank’s Decision
The BoC has intended to reverse the two rate cuts it implemented in 2015 for some time now, with Governor Poloz stating that the cuts had “done their job”. The pace of economic growth has been surprisingly strong this year, which was a key factor behind today’s decision, with emergency-level monetary accommodation no longer warranted. The Canadian economy expanded at a 3.7% annualized rate in the first quarter of 2017, outpacing many of its developed market peers. Growth was largely driven by domestic demand and household consumption, while residential and business investment were also strong. Going forward, Governor Poloz expects the pace of growth to stay above potential, which could lead to another hike later this year or in early 2018 if the pace of economic activity remains supportive. Also, the labour market (figure 2) has remained strong, which has produced more jobs than expected. However, similar to the U.S. Federal Reserve and other major central banks, inflation has been weak and has lagged its 2% target (figure 3), which could delay policy decisions. Still, the central bank played down low inflation figures, saying most of it is “transitory” and is a result of competitive pricing in the grocery business. Additionally, the central bank has stated that any monetary policy decisions must look forward to where the economy is expected to be in 18 to 24 months, as opposed to where it currently is.
Figure 2: Solid employment has supported stronger economic growth
Source: Bloomberg. Monthly data to June 30, 2017
Figure 3: Despite weak inflation, the central bank still hiked rates
Source: Bloomberg. Monthly data to June 30, 2017
Central Bank Comments and Market Reaction
Given the breadth and overall strength of the expansion in Canada, the central bank felt the economy could easily handle higher rates. The bank also upgraded its assessment of the economy as it anticipates growth of 2.8% in 2017, up from 2.6% in its April outlook. Growth is expected to moderate to 2% in 2018 and 1.6% in 2019. Governor Poloz stated that he is not ready to say when a second rate hike is coming, though any future decisions would be based on “incoming data” on inflation.
The material shift in the Bank of Canada’s tone in June resulted in a significant re-pricing of short rates and the Canadian dollar during the last several weeks. Given the bank’s more hawkish comments following July’s hike, the market is increasing their expectations of additional rate hikes down the road. This has resulted in an increase in bond yields in the short end of the Canadian yield curve (up to 10 years in maturity, though more so in two- and three-year maturities) as well as further appreciation of the Canadian dollar. Yields in the long end of the curve have declined modestly as inflationary pressures remain low.
AGF Fixed Income Team’s View
We anticipated the July hike, viewing the central bank’s significant policy shift in June as a strong signal of their intent to begin hiking rates. Due to the broad-based recovery and the central bank upgrading its assessment of the economy, we believe that this is not just a reversal of the two emergency cuts back in 2015. Rather, we believe this sets the stage for the continued normalization of policy rates, albeit gradual. We anticipate one additional hike this year and further potential hikes in 2018. We will closely monitor incoming inflation and other economic data as this will continue to determine the central bank’s policy stance and play a key role in determining the direction of short rates in Canada as well as the Canadian dollar.
We believe that yields will remain range-bound in the medium term and the Canadian dollar will remain at the higher end of its recent range.
Impact of Higher Rates
Mortgage rates already started to rise ahead of the decision, in anticipation of the central bank’s potential hike. Higher interest rates means that consumers will be paying more on variable-rate mortgages as well as on any new fixed-rate mortgages. Other borrowing costs will increase, including other loans and lines of credit that are tied to the benchmark rate. The impact on housing is likely to be moderate. The Toronto housing market had already cooled prior to the rate hike, as a result of the Ontario Liberal government’s decision to implement policy measures back in April 2017. There were buffers put in place at that time that forced new buyers to qualify for mortgages at much higher rates than current market rates. As well, disposable income growth has been solid, at approximately 4% year over year, which is more than enough to cover the impact of modestly higher mortgage rates. As it pertains to the economy, growth has been strong and can handle higher interest rates. The U.S. dollar/Canadian dollar and the real effective exchange rate are currently where they have averaged over the last two years, which is what matters for lagging trade effects. Additionally, increased income from higher interest rates can help offset negative price effects from the exchange rate.
Commentary and data are sourced from Bloomberg and Reuters except where referenced. The commentaries contained herein are provided as a general source of information based on information available as of July 12, 2017 and should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein.